S&P Lawsuit Portrays CDO Sellers as Duped Victims

Feb. 6 (Bloomberg) -- Oh, the poor suckers at Citigroup
Inc. and Bank of America Corp., fooled about the stench of their
own garbage by those sneaky credit raters at Standard & Poor’s.

The U.S. Justice Department made some peculiar allegations
in its lawsuit this week against S&P and its parent, McGraw-Hill
Cos. According to the government, Citigroup was defrauded by S&P
credit ratings on subprime mortgage bonds that Citigroup itself
created and sold. Bank of America, too, allegedly was defrauded
by S&P in the same way.

If this doesn’t make sense, that’s the point. The notion is
far-fetched. No wonder S&P wouldn’t agree to a settlement and
told the government to see it in court.

Here’s the gist. Near the end of its 119-page complaint,
the Justice Department listed about two-dozen collateralized-debt obligations issued in 2007 as examples where S&P allegedly
defrauded banks and credit unions. It was important that the
Justice Department be able to identify such lenders as
investors, because it’s suing S&P under a 1989 statute that
covers frauds against federally insured financial institutions.

Under the government’s theory, Citigroup and Bank of
America paid S&P for ratings that convinced the banks their own
CDO offal was rock-solid. And because S&P deceived them into
thinking the best of their own rubbish, these banks and other
lenders suffered more than $5 billion of investment losses,
according to the suit.

Harmed Investor

For nine of the CDOs, the government’s complaint listed
Citigroup as the harmed investor -- without mentioning that
Citigroup’s investment-banking division had managed the bonds’
offerings. The complaint identified Bank of America as the
defrauded CDO investor in two instances, also without mentioning
that its securities unit underwrote those bonds.

It’s a novel concept. If only S&P had given honest opinions
to Citigroup and Bank of America -- which were paying S&P
millions of dollars for ratings -- then the banks would have
realized they were buying ticking time bombs from themselves.
And who knows? Maybe they could have found some other hapless
chumps to immolate instead, if S&P had told them in time.

One of the CDOs was a $502 million deal called Plettenberg
Bay. The government’s suit said S&P rated $436 million of the
debt AAA, its highest mark, and that “Citibank suffered an
almost total loss of its investment” after buying $8 million of
the CDO’s lower-rated tranches. The suit didn’t mention that
Citigroup was the CDO’s underwriter, or that other Plettenberg
Bay investors are suing the bank over their losses.

Under the government’s version of the facts, S&P’s fraud
caused the banks’ losses, and Citigroup and Bank of America were
victims. I would hate to be a government attorney who has to
stand in front of a jury and try to make that argument.

I asked Justice Department officials to explain how the
underwriter of a CDO could be defrauded by an S&P rating on the
CDO it underwrote. (The bank that sold the CDO should know more
about it than S&P does.) Here’s the response:

“Some of the federally insured financial institutions
whose losses are identified in the government’s complaint had
operations involving the securitization of mortgages or other
types of collateral,” said Charles Miller, a Justice Department
spokesman. “This involvement does not prevent the United States
from seeking to recover civil penalties relating to these
federally insured financial institutions.”

So one unit of Citigroup can lose money on fraudulently
rated bonds that were concocted by another part of Citigroup,
and the government can sue the rating company for penalties --
as if S&P’s opinions actually mattered to Citigroup’s divisions
when they were buying and selling the dreck to each other.

In real life, it probably will be hard to convince anyone
that S&P deceived Citigroup or Bank of America about the safety
of their own monstrous creations. S&P’s ratings duped lots of
investors, for sure -- but these investors? Come on. It’s almost
like the feds are suing on the banks’ behalf.

Losing Money

A Citigroup spokeswoman, Shannon Bell, declined to comment
when asked if the bank believed it had been defrauded by S&P. I
put the same question to a Bank of America spokesman, Jerry
Dubrowski. He, too, declined to comment.

There are other CDO investors cited in this week’s
complaint, including M&T Bank Corp., that didn’t underwrite the
S&P-rated bonds on which they lost money. Maybe the government’s
claims over their losses will stick, even if the allegations
related to Citigroup and Bank of America don’t.

Perhaps the Justice Department deserves credit for at least
trying to hold one of the major credit-rating companies
accountable for helping cause the financial crisis. That could
be a step forward after years of inaction. During a news
conference this week, Attorney General Eric Holder said his
agency’s investigation of S&P began in November 2009 -- more
than two years after it became obvious that Moody’s Corp. and
S&P’s mortgage-bond ratings were worthless.

It would have been far better if the Justice Department’s
case didn’t have its own glaring credibility problem.

(Jonathan Weil is a Bloomberg News columnist. The opinions
expressed are his own.)